Capitalization means taking a chance or gaining an advantage from any asset or possession. You can convert anything into capital, by setting future benefits against the cost of maintaining the asset. The rate of capitalization (also commonly known as cap rate') is normally a ratio between the original cost incurred in acquiring the asset, measured against the income produced by operating or utilizing the asset for financial gain, after deduction of the fixed and variable costs that are incurred in maintaining the asset.
With this ratio, an investor is able to estimate the duration taken by the asset to pay for itself. Of course, there are several other factors to be taken into account, such as the nature of the asset, its usage, depreciation of all assets related to the main asset, break-down or failure in functioning of the asset for considerable period, that could lead to asset becoming non-productive and so on.
As a simple illustration, capitalization rate can be calculated as follows:
You purchase a building worth $1 million, earn $200,000 in lease rent during a particular year, incur $50,000 as fixed and variable costs in maintaining the building and wish to calculate the capitalization rate of this building. This is simply done - first deduct fixed and variable costs from the lease rent earnings, divide the purchase cost paid for acquiring the building by the remainder of the annual earning once the fixed and variable costs have been deducted, the resultant number is the capitalization rate for the building. Going by the above example, the capitalization rate will be 6.6% (1 million/150000, where the denominator is derived by subtracting 50k as costs from the annual lease rent earning of 200,000). This could also mean that in 10 years, the asset would have paid you back over 60% of the cost incurred in acquiring it. Of course, this is subject to the assumption that there is no change in values of expenditure and income earned from it.
If you are a lay investor without much background or experience in the financials of capital assets, but have the money to invest and would like to assess the soundness of your investment, it is most essential to seek professional assistance of a tax advisor, a professional appraiser or assessor and an auditor. Depending upon the nature of the property such as a building and its value, you can consider retaining services of an architect too. All these professionals together should be able to provide you with a fairly accurate calculation of capitalization rate for your asset (in this case, a building) by taking into account various input costs, fixed and variable costs, future income and so on.
Do remember that different countries calculate the capitalization rate in varying fashion, as in, the inputs/components for calculation could vary. For example, treatment of costs towards depreciation and debt servicing; also, based on the value input, whether it is the asking price, the selling price or the fair market value, your final capitalization rate could vary.
In certain instances, there are readymade financial spreadsheets available with all necessary values provided therein. Do look for one, which enables easy calculation of the capitalization rate.
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